Saturday, July 25, 2009

Reforming Money - Fixed Fiat Currency


I have long promised a discussion of a system of fixed fiat currency, and the discussion that follows is my first attempt at this। It is a very long discussion, and I hope that you will have the patience to plough through such volume (I guess that many will not). However, I do hope that it will prove to be an interesting potential system that might help prevent a repeat of the current economic crisis.

The fixed fiat currency system proposed here will not please any school of economics, as within the proposed system is something to cause consternation within each school. The discipline of macroeconomics is currently going through a period of turmoil as a result of the economic crisis that is engulfing the world. Leading economists such as Krugman are calling into question many of the foundations of macroeconomic theory, and debate is commencing on both the causes and solutions to the current economic crisis. The fixed fiat currency proposed here is an addition to that debate.

In order to understand the fixed fiat currency system there is a necessity to return to the basic question of what money actually is. Furthermore, once the nature of money is explained, it is apparent that any system of money must also include non-traditional forms of money, and that will mean that the proposed system must also take into account the financial system.

The proposed system is not perfect. It will not remove booms, it will not provide for social justice or any other ‘magic’ solution to the economic ills of the world. However, it offers greater stability, transparency and above all honesty and fairness. The latter notions are curiously absent from most macroeconomic discussion, which is puzzling as economics has a foundation in human endeavour.

The article is sparsely referenced, but includes ideas such as the value of labour which is rooted in the work of Karl Marx, critiques of fiat money which owe a debt to the many articles on the von Mises Institute website, and the overall theory and work of Adam Smith in the Wealth of Nations is an important overall inspiration.

There have, of course, been other sources, but none of these are specific such that they might be referenced. Overall, the majority of the considerations are the result of personal analysis and thought arrived at independently. This does not preclude the possibility of others already having come to similar conclusions or ideas, and I will apologise in advance if these ideas have been proposed by others.

Due to the relatively independent way in which this has been considered, robust but polite critiques are welcomed. It is, after all, the musings of an individual barely schooled in any economic theory.

The Nature of Money

The first point to make is that all economic activity is rooted in the value of labour. A commodity such as gold only has value once labour has dug it from the ground, and labour has moved it to the surface. Once it arrives at the surface it will be some form of labour that is utilised to move it to where it is next utilised.

For example, if a commodity is moved by truck, the truck represents a store of the value of labour of others, with the truck being a representation of a long chain of economic activity rooted in labour. From the commodities dug from the ground and being processed, the transportation, sale and processing of the commodities, the purchase by component manufacturers of the commodities and the final assembly of the truck, each step of the manufacture of components is rooted in the labour of individuals.

At the heart of all economic activity is human labour, and economics is the process of exchange of value of labour between individuals, organisations and other economic units.

Within this system of exchange of value of labour, the underlying purpose of money is very clear. It should only act as a medium through which the value of labour might be accounted, and is always representative of a store of value of labour, with an underlying contract that it might, at some future point in time, be exchanged for the value of labour of others.

Any system of money should seek to represent the value of labour in a way that is both fair and stable, such that the underlying contract is met regardless of elapsed time. Such a system implies that the value of money should be a neutral token to be used in the exchange of value of labour, such that it offers a fair exchange as determined by how individuals and organisations value the labour of each other. The purpose here is not to discuss the rights and wrongs of how one person’s labour might be valued against another, which is a debate about social justice, but rather to identify that all economic activity is the exchange of value of labour.

If we view what might constitute money as it is defined here, it is possible to see that there are two forms of money that operate within an economy. The first form of money is the issuance by government of fiat currency, which might be called ‘traditional money’ for the sake of ease of expression. This is the money that is currently created by central banks in the form of banknotes and coins, as well as by entries in the balance sheets of banks. At present, the issuance of such money is controlled by central banks according to their understanding of the underlying state of the economy, and historically has seen a progressive and continual expansion of the money supply wherever the system has been enacted.

The other form of money is IOU money. To illustrate the principle of IOU money, a simple illustration might serve to explain how it is created, and from where the value in IOU money is derived. This will also aid in understanding of the value of traditional money, as the two types of money interact throughout an economy, and traditional money is just a particular form of IOU money.

If we think of an individual (we will call him Fred) in a small town who is short of traditional money, he might visit his local pub and talk with his associates in the pub about exchanging his labour in return for pints of beer. In return for the pints of beer, Fred might promise the individuals who are buying the beer for him that he will mow their lawns which will take one hour of his labour in their garden. This means that one pint of beer = one mowed lawn, which represents one hour of labour for each pint of beer that has been purchased for him. As he is drinking beer, he is worried he will forget to whom he has offered his services, and will therefore provide a slip of paper offering one mowed lawn to be undertaken next week.

Fred, being a heavy drinker, starts to issue many IOUs and Henry has exchanged pints of beer for two IOUs. However, on reflection, Henry decides that he only needs one mowing of his lawn next week, and wonders what he might do with the IOU. He then sees a friend with a sandwich and offers the IOU to the friend, in exchange for half the sandwich. The friend accepts the IOU and provides half a sandwich.

What we are seeing is the creation of money. Fred, in offering a future commitment of his labour, is creating IOU money. It serves as money, as the IOU notes have become a recognised unit of exchange. When the person exchanged the sandwich for the IOU, he was exchanging the sandwich on the basis that the value of labour stored in the sandwich would be exchanged in the future for the value of Fred’s labour. In so doing an exchange of labour has taken place, and an underlying contract has been created. The IOU also acts as a measure/account of value of labour, as we are starting to see that one hour of labour in a garden = one pint or half a sandwich.

At the moment, Fred’s IOU money is ‘good’ money. Everybody in the pub accepts Fred’s IOUs as money, and Fred continues to drink beer in exchange for the IOU money. At the end of the first day, rather drunk, he staggers out of the pub having exchanged 15 IOUs for pints. He returns to the pub the next day and, being a heavy drinker, does the same thing. On the third day that he returns to the pub, he tries once again to make the exchange of IOUs for beer. However, as he enters the pub, he meets a cold reception.

Fred now owes 30 hours of gardening for next week. An individual in the pub has pointed out that Fred is already employed by a gardening firm, and that his ordinary working hours are 40 hours per week. This will mean that next week, Fred will need to undertake 70 hours of labour. There are doubts in the pub that he is this hard working and, just before he came into the pub, one of his IOUs was therefore hurriedly exchanged for a packet of peanuts, which are half the price of half a sandwich in traditional money. Confidence in the money being issued by Fred has fallen. The currency has devalued due to lack of confidence in Fred meeting the contract in his IOUs.

Fred is thirsty and alarmed at the lack of confidence in his IOUs. He therefore decides to take measures to restore the value of his IOU money. He explains to everyone in the pub that, if he does not meet his gardening commitments, he will instead provide the holders of the IOUs with some of his gardening tools. Whilst many people do not want the gardening tools, having the IOUs backed by the tools means that, at least, if all else fails, they might sell the tools in lieu of the labour owed. Fred’s IOU money is now backed by assets, and Fred is now able to continue exchanging IOUs for beer.

Within this scenario, it is possible to see how the value of money is created and maintained. In all cases the money is backed by, or representative of, the value of labour. Even when Fred backs his IOU money with his tools, the tools represent a store of value of labour of others. In all cases, the money is an IOU of value of labour, and the value of money is determined by the confidence in Fred’s ability to deliver that value next week.

In the case of traditional money, the same thing occurs. It is accepted on the basis that it will, at a future point in time, represent a contract for the exchange of labour. It is identical to what Fred has done, but is different in that it represents a wider pool of labour, and is abstracted away from being a single variant of value of labour. Whilst Fred’s money uses units of one hour of gardening as the base unit of measure, traditional money has no single base unit to measure against. This is different to, for example, a gold standard currency, in which the commodity becomes the base unit of measure.

We can also see in the case of Fred how money holds value when supported by an asset. If we look at a commodity standard, or the issuance of asset backed securities, we can see that asset backed money simply offers a substitute of stored value of labour in place of the future commitment of labour.

However, there is a problem with asset backed money. If we imagine that Fred is very lazy, and fails to meet his future commitment of the value of his labour, he will have to offer a large number of his tools in lieu of his labour. Many of the recipients of the tools will want to sell them, and the result will be a flood of tools being offered for sale in the local classified section of the local newspaper. However, there is no reason why there might be a sudden demand for so many tools within the town, and therefore many of the tools cannot be sold. The holders of the tools are faced with holding on to the tools in hope of later demand for the tools, or selling them at a steep discount. They believed that the tools were a substitute for the hour of gardening labour, but find out that they are not.

This point is the underlying problem with any asset backed form of money. Whilst, in the case of Fred, he has offered an assurance over and above his promise to deliver, the value of that underlying assurance does not necessarily represent the actual value of labour that is contracted in the money that he is issuing. The same point may be made for any money secured by an asset, such as gold backed currency. The value of the underlying asset is subject to fluctuation, such that it may advantage or disadvantage the holder of the money, with no reference to any labour undertaken by the holder. The same might be said for any commodity currency, such as gold coins or silver, which might be subject to variations such that each unit changes value in relation to the value of labour.

What is apparent from the example of Fred’s money is that the only real value of money resides in the meeting of the underlying contract of provision of value of labour. In other words, the only way to achieve the full value of Fred’s IOU money is for Fred to actually do the hour of gardening work promised in the IOU, which means one mowed lawn. In practical terms, therefore, any good money system should not be based in assets but in firm commitments for the fair exchange of the value of labour at a future point in time.

Current Fiat Currency Systems

In the current fiat currency system, it is apparent that the currency is neither fixed against an asset, and is not fixed against any value of labour in the economy. The issuance of the money is not referenced to the potential output of value of labour in the economy, and the supply of money is continually inflated. It is like Fred offering ever more IOUs regardless of whether he might meet the contract for each unit offered. The issue of each unit of currency does not represent the actual value of labour in the economy, and is issued independently of this.

An interesting comparison with current fiat systems is the issuance of currency in the online world of Second Life. It is a currency issued by the owners of the Second Life world, is utilised for exchange within the world and can be converted into $US through a currency exchange. Both currencies are as arbitrary as one another, as neither currency is rooted in anything. People are now earning a living in Second Life, and use the currency exchange to allow them to convert their online value of labour into ‘real world’ money.

As an example of the problem of un-rooted currency, if we were to imagine the economy has a total daily output of 100 units of labour, and Joe provides one unit of that labour, the value of Joe’s labour is worth 1% of the total value of labour in the economy. If today we have 100 units of money in circulation, Joe will be given 1 unit of money as a result of his labour, and Joe would hope to be able to exchange his money for 1% of the total value of labour the next day. However, if the units of money are increased by ten units the next day, then Joe’s 1 unit can no longer be used in exchange for the 1% of the total value of labour.

The problem arises as to where that value of Joe’s labour has gone? He undertook the labour, stored his labour in the unit of money, and some of it has now disappeared. He might reasonably think that this is unfair and unjust. He might reasonably ask where that value has gone.

The value has, of course, been transferred to the newly issued money। They have, in effect, taken some of the value of Joe’s labour from him. Whoever issued the money, they are now in a position to utilise that value of labour that has taken from Joe to exchange with the value of labour of others. In so doing, they have expropriated some of the value of Joe’s labour. Any such system is inherently unfair and unjust. The new holders of the value of Joe’s labour have not actually done anything which might justify their expropriation of his labour. If Joe’s labour was building a brick wall, and his payment was made for this task, it is not clear how someone who made no efforts or contribution to the building of the brick wall might have a portion of the value of that labour of building the brick wall.

An interesting point to note is that, once a central bank creates money, as is pointed out by the Austrian economists, the first recipients of the newly created money are banks. The earlier the money is utilised, the greater the value of the money that is retained, as it takes a while before the newly created money creates inflation in the economy. The issuance of new currency is therefore beneficial to the banks that receive it.

The problems extend beyond this. Such a system also undermines the utility of the money as a neutral account of the value of labour. If the supply of money is variable, it is not possible to calculate the relative value of labour now with the value of labour in the future with the money. How is it possible to exchange the money today at ‘x’ units of value of labour, if we do not know that we will, in the future have ‘x’ units returned to us. It makes the value of money arbitrary, and inherently unstable.

Furthermore, in the current world trading system, it is apparent that it is possible to manipulate currency issuance in order to pursue quasi-mercantilist policies. It is also possible for governments to impoverish sections of their society in order to meet state goals, and to hide fiscal imprudence through the manipulation of currency. These points will be discussed later.

Fixed Fiat Currency System

The only way that a system of money might offer both stability and fairness is to instigate a system of money that represents each individual’s actual input of value of labour into the wider economy that is utilising the money. The only way to do this is to fix the currency against the actual value of labour in the economy. This means that each unit of money becomes a token that represents ‘x’ percent of the total value of labour in the economy. In order that the token always represents such a percentage, the number of tokens must be invariant.

There are several advantages in such a system, which will be addressed later, as follows:

1. A fairer system of money, that allows more individual freedom of choice
2. Greater stability of the financial system, with a tendency towards consistent and steady price deflation
3. A system in which asset and other bubbles might be more evident, providing an early warning of the formation of bubbles
4. A more transparent world trading system that has self-balancing characteristics, and which will provide a fiscal discipline upon government
5. Allowance for a more transparent banking regulation system, and the removal of most current banking regulation.

The Problem of Currency Units

One of the potential arguments that might be provided against a fixed fiat system is that it provides for a system that will trend towards deflation (discussed later). In a situation of continual deflation, there is a potential problem with the utility of currency units. This is best illustrated with an extreme example. If we were to imagine that the Normans has instigated a fixed fiat currency in England in 1066, and there were 100,000 units of currency, each unit today would hold a value of labour that would make such units impractical for day to day usage.

As such, it would be necessary to break such units up into smaller units, to allow for the multitude of small exchanges that are necessary within an economy. The way that this might be accomplished without the inflation of the money supply is to view each unit of currency as if it were, for example, a loaf of bread. If the loaf is cut into smaller slices to share it out, the loaf of bread remains but in the form of many slices. It is still just one loaf of bread that is being shared out.

In the same way, as each individual currency unit becomes less useful, the currency would then be subdivided into smaller units, with the subdivision meaning that there is no actual change in the overall value of the original unit, just that the value is split amongst the new units. In practical terms, if we issue 100 pence in coins, we must destroy the £1 note that was divided.

Steady Deflation

One of the great advantages of a fixed fiat currency system is that it provides for a system which will achieve steady and consistent inflation. The assertion that this is advantageous might horrify many economists, and therefore requires some explanation. In particular, there appears to be a widespread belief that deflation is a ‘bad thing’. There is no evidence that this is the case, but rather there is plenty of evidence that a change in the rate of inflation or deflation, or a move from inflation to deflation is damaging.

However, before moving to the effects of change, it is worthwhile destroying some myths about deflation. The first myth is that deflation prevents individuals from making purchases, whilst they wait for better prices. In the following examples, it will be shown that the reality is that people do not delay purchases in the expectation of lower prices.

Example 1 – Fast Moving Consumer Goods

If a shampoo manufacturers were to improve their output by 5% through a manufacturing innovation each year, their output of shampoo would increase, and this would reflect in a decrease in the price of shampoo. In other words, there will be a steady and continued deflation in the price of shampoo. According to the idea that consumers will delay purchases in an environment of deflation, in such a situation, consumers would choose to walk around with greasy hair, never buying shampoo in the expectation of further price decreases. Such a proposition is fatuous.

Example 2 – Hedonic Goods

Over the last few years countries such as the UK have seen the emergence of many discount airlines, such as Easyjet. The emergence of these kinds of airlines, and the increase in competition within the sector, has seen the price of air travel deflating. Much of the utilisation of these airlines has been by consumers using the discount airlines to have cheap foreign holidays, and this can be described as a hedonic good. It is an entirely discretionary expenditure as there is no necessity to go on holiday to another country. Despite the continual deflation, there have been many years of continual expansion in the discount air travel market. The deflation has not prevented consumers from taking flights to go on holiday, but rather has had the opposite effect.

Example 3 – Computers

Personal computers (PCs) are an interesting case, as they have year on year improved performance and year on year seen deflation of actual prices. It is also an example that includes both business purchases and consumer purchases. Despite the ongoing deflation in the prices, the market for PCs has had a long period of explosive growth throughout this deflationary period. It seems that the steady deflation in prices has had no impact through the postponement of purchases.

Example 4 – Special Cases

Remaining with the example of PCs, it is possible to construct a hypothetical example of how consumers might indeed delay their purchase in expectation of deflation. If one of the large computer manufacturers were to announce that they would be introducing a new type of computer in the coming year, and that the computer was to offer twice the performance at half the cost, it is quite likely, assuming their claim were credible, that consumers might delay their purchase of computers in expectation of this future deflation.

If the thinking of those who argue against deflation is considered, such a deflation is a ‘bad thing’ as consumers withhold their money in expectation of lower prices. If this logic is followed, then the new and more effective design of computer is not a good thing for the economy, as it has created a deflation in the price of computers, and has caused a delay in the purchasing of computers. However, once the computer is introduced, it will make more computing power available to more people. How this might be a ‘bad thing’ is not entirely clear. Everyone who purchases a computer sees their wealth increase, as they are able to enjoy relatively more computing power in relation to their income. They are quite literally wealthier.

Debt and Deflation

There is an argument that suggests that deflation causes problems with the servicing of debt, as the value of the debt sees relative increases through the deflation. This is a scenario that appears to be very plausible, and can be backed by some solid calculations and formulae. However, what is missed in such arguments is that it is not deflation that is problematic, but the move from inflation to deflation. It is not the change in the value of money that is problematic, but the change in inflation/deflation from the original inflation/deflation position from the time of the issuance of the loan.

A good example of this can be seen in private mortgages on housing. If a loan is taken out in a high inflation environment, the interest rate will be relatively high. The targeted central bank interest rate will be high, and the lenders will seek to account for the high inflation by charging a rate of interest that will overcome the devaluation of the money that they are lending, such that they can achieve a positive return. If the interest rate is fixed over a period of, for example, five years and at year four the rate of inflation has fallen by a half, the holder of the debt is effectively seeing the value of their debt inflating. The earlier rate of inflation was eroding the value of their overall debt, and this was accounted for in the interest rate. However, with inflation falling, their debt value is no longer declining at the same high rate, but they are still servicing the debt as if this were the case. Their payments in relation to the actual value of the debt have increased.

If we think of this example and think of a change in the rate of inflation from 5% to 2%, and compare this with a change from 2% inflation to deflation of 1%, we can see that there is the same process taking place. In both cases we are seeing the relative burden of debt in relation to income moving in exactly the same way. In the inflation and deflation environment, interest rates will move to reflect the underlying changes in the value of money, and debt burdens will be locked into repayments that are based upon an out of date criterion.

In other words, it is not inflation or deflation that is problematic, but rather it is the change in inflation/deflation that alters the burden of the debt. As such, any monetary system should aim to achieve either stable inflation or stable deflation.

Fixed Fiat and Deflation

A fixed fiat system does not guarantee stability of deflation, but does have features which will inherently stabilise the rate of deflation. If it remembered that a fixed fiat currency is tied to the total value of labour in the economy that is issuing the currency, it is apparent why this is the case.

If output of value of labour in an economy increases, the value of labour per unit of currency will also see a commensurate increase. This is the deflationary effect of a fixed fiat currency. However, there is no guarantee of an increase in output of value of labour. For example, if there were no technological or process improvements over a period of time (unlikely), then there would be no inflation or deflation. Equally, if for example there were a natural disaster that destroyed infrastructure, then the output from the economy would fall, creating inflation.

External inflation such as an increase in commodity prices might also create inflation, though these inputs might reasonably be isolated from the overall measure of inflation/deflation in the economy. These are factors that can not be changed from within an economy, as they are resultant from both internal factors and external factors that are beyond any action in any individual country. For example, if there is a poor worldwide harvest of wheat, this might see food price inflation across the world.

No monetary policy or manipulation of the money supply will alter the amount of available wheat in the world. As such, any shift in prices of commodities might cause a temporary shift in inflation/deflation, but there is no monetary policy that might influence this. The only thing to do with such changes is monitor their effects, and try to strip out their effects from the trend of inflation and deflation.

In most cases, deflation will follow the gradual and progressive level of increased efficiency resultant from step-by-step innovations in process and technologies. However, if there were a major innovation, such as the introduction of new highly efficient technology, there might be a resultant period of relatively high deflation, as output increases rapidly such that the value of each unit of currency rapidly increases.

Real cases in history that might cause rapid deflation in a fixed fiat system would be the introduction of electricity into manufacturing, or the introduction of railways. In both cases, the introduction of the technologies resulted in higher output per unit of labour, such that there was a widespread overall increase in the value of labour across the economy. This is a positive form of deflation, as the overall output of value of labour has increased without an increase in the volume of available labour. The economy has simply become wealthier. This is best represented in the earlier argument about the introduction of a far better PC. We should wish for this kind of dramatic deflation.

Hoarding of Money in Deflation

It is possible to read in accounts of deflation the use of the word ‘hoarding’. Before discussing why people might invest in a deflationary environment, it is worth addressing the word ‘hoarding’. It is a word with particular connotations, such as the idea of a dragon hoarding gold. Within such connotations it is possible to perceive that there is an emotive meaning in that the word implies selfishness and greed. The use of such an emotive word should therefore start to ring alarm bells, as it is a rhetorical device rather than a reasoned argument.

However, there is an underlying concern that, in an environment of deflation, people will simply use cash as their method of saving, rather than using their money to invest in new productive activities. This appears to be a plausible argument.

Nevertheless, it is not as plausible as it seems. The underlying argument is that, if there is deflation, the value of cash is in any case going to increase over time, so why would an individual risk making an investment if they can just ‘sit on’ their cash and see a positive return.

The problem with this argument is that it does not account for the variable levels of risk that individuals are willing to take in order to see a return on their money. For example, in the environment pre-economic crisis, there were a range of investment opportunities, each with a relatively different level of risk. An individual in the UK might have placed their money in government bonds at a low rate of return but with very low perceived risk, or they might have invested their money in a perceived high risk and potential high reward emerging market tracker fund. We know that people invested their money in both of these investments, and this clearly demonstrates that different individuals at different points in their lives will be willing to take varying risks with their accumulated store of the value of their labour.

In a situation of steady deflation, the behaviour of individuals will not change. Some individuals will ‘sit on’ their money, and others will seek to gain a return on their money that is greater than the return provided by the deflation. The key difference in the system is that the necessity of investment is taken away, such that no individual is forced to risk their capital. If we think of an individual approaching retirement, due to continual inflation, they must risk the value of their labour stored throughout their life, if they are to retain the full value of the store. In doing so, they also risk the loss of that capital with the result that they might live through an impoverished retirement. There seems to be no reasonable justification to force such a risk on any individual.

Within a fixed fiat system of steady deflation, it is apparent that some individuals will utilise their store of labour value to invest in order to gain a return, and others will enjoy the benefits of retaining the value of their store in relative security. Whilst there are no guarantees that sitting on cash will preserve the purchasing power of that cash (e.g. the natural disaster example), the holder of the cash has the assurance that he/she will remain as wealthy relative to others under all circumstances.

Interest Rates and Investment in a Fixed Fiat System

In a period of steady deflation, how will investment actually work? It is an interesting question that is far simpler than it might first appear. If we were to imagine a steady rate of deflation of 2%, how might interest rates be determined?

As has been outlined, it is possible to ‘sit on’ cash, and that cash will then yield an annual return of 2%. In order to persuade an individual to invest, it is necessary to offer a higher yield relative to the perceived risk in the investment. In looking at the problem this way, it is apparent that investment decisions are no different to the choice that was outlined in the example of an inflationary environment. If inflation is running at a rate of 3%, an individual might seek a real return on their investment of 5%. As such, they will direct their investment to an area where they will expect a total return on their investment of 8%. If the rate of deflation is 2% they will, using the same calculation, seek an investment with a return of 3%. In both cases they are aiming for the same real return, and will make the same risk/reward calculation. There is absolutely no difference except that the individual has a choice on whether they might invest their money at all.

What if the rate of deflation was very high? The first point to understand is that a high rate of deflation means that the economy is actually very successful. It simply means that the output of the overall value of labour has seen a significant increase. In real terms, the economy is wealthier overall.

However, should the deflation reach a very high level, for example an extreme deflation of 10%, there will be a problem in presenting investments that might attract individuals to take risks. The rate of return on the investment would have to be very high, as few people would be willing to take risks when they can earn a 10% return by ‘sitting on’ their cash. The result would be that the flow of money for investment would diminish, and the speed of the growth in the output of the economy would be constrained. The question here is whether this might be a good or a bad outcome.

If the output of the economy is expanding at such a rapid rate, it is quite possible that there will be a period in which there will be ‘irrational exuberance’. The history of the many examples of how individuals might become carried away with a particular class of investment needs no retelling, from the South Sea bubble, to the more recent housing bubble.

However, there have also been other bubbles which have been resultant from the introductions of new technologies, such as the telecoms or Internet bubbles. In both cases, there were significant innovations which had potential to increase output in the economy, and in both cases early investment yielded strong returns. However, in both cases the early returns led to manias, and those manias saw significant overinvestment in the sectors, so that overinvestment took place with a resultant misallocation of resources.

In a fixed fiat currency system, the deflation that would result from the expansion in the economy would present a natural stabiliser on investment during technological innovation. It might be argued that the high deflation would ‘starve’ the new technology of capital for expansion, but the opposite view is that each innovation might be ‘digested’ before any manias developed. This is not to say that a fixed fiat system would guarantee no manias, as people will always have the potential for ‘irrational exuberance’ under any system. However, if an innovation creates dramatic deflation, the deflation might cause far greater caution in further investments, and therefore act as an automatic stabiliser.

As the drop in investment takes place, the growth in the output of the economy will start to moderate, and the economy should stabilise back towards a steadier rate of deflation. Whilst giving the extreme example of 10%, it is unlikely that there might be such extremes, as the stabilising effect is progressive and self correcting. One of the underlying strengths of the fixed fiat system is the inherent self-stabilising effect, such that investment and borrowing should be taking place in a steady rate of deflation, thereby ensuring that lending and borrowing do not see volatility such as the alterations in the costs of servicing debt burdens.

Stability of the Financial System

At the start of the discussion, it was identified that there are two types of money in an economy, broadly characterised as traditional money and IOU money. Up to this point IOU money has not been discussed, despite the important part that it plays in the system of money overall.

Whilst the fixed fiat money system might create a steady deflationary tendency, it does not account for the rise and fall in the supply of IOU money. This raises the question of how IOU money might be regulated such that there are no booms or busts due to overexpansion or contraction of this money supply. As has already been identified, there is a natural stabiliser which should ameliorate bubble forming investments and activities, but this does not fully account for expansion of IOU money. For example, if deflation is very high, it might be that one company will less willing to extend credit to another company. This is a natural circuit breaker on the economy in which fast expansion will see a commensurate contraction in credit.

However, one of the main sources of IOU money is the banking and financial system, and any stability in the monetary system must therefore ensure some stability in the creation of IOU money in the banking system. The temptation here is to introduce a system of complex regulation, and enforce various measures upon the banks. However, the use of a fixed fiat system, alongside provision of particular information, offers a simpler and more effective method of managing the banking system.

The first point is that the fixed fiat system allows individuals to hold cash at very low risk to their stored value of labour. This extremely low risk allows for the creation of what might be called ‘deposit banks’. These are banks which literally, for a small fee, will store the money of an individual, with the entire holdings of deposited money always available for return. This is so essential to the system that, if no private institution were established to offer this service, the government would need to offer such a service. The function of the deposit banks is simply to store the money, facilitate transfers and transactions, and a fee would be needed to pay for the services.

The reason for the necessity of these banks is that each individual must have a clear and available choice of a bank which does not does not risk their stored value of labour. In having this choice, individuals have real choice in the way that they risk their money.

The second element of the financial system is ‘speculative banks’, which are any banks or financial institutions which might not, on any given day, be able to return all of the deposits that they have taken. These are any financial institution that takes depositors money and uses it for any kind of investment. In all such banks, at least proportions of the deposits that are held are at risk of loss, and can not be returned on demand. The name of this type of bank is explicitly given to remind any depositors of money into the bank that they are speculating, and the banks would be regulated such that they would need to include the name speculative bank in their name.

However, the most important element of the regulation of these banks is not their name, but something more fundamental. It is essential that depositors into the speculative banks are aware of how much of their deposit is subject to risk at any particular period in time. For the sake of pragmatism, this information should be available on a daily basis, and would need to be published daily in all branches of the bank, and on the bank’s website homepage (in a specified format). In particular, each bank would need to give an exact percentage of their deposits available for withdrawal as cash on the previous day, as well as a rolling trend for the percentage. This information will ensure that every depositor is fully aware of the amount of their deposited money that is at risk. The penalties for the provision of false information would need to be severe.

The third element of the system is the provision of information about the nature of the risks being taken by the speculative banks. At present, there is no regulation that prevents the banks from paying for external assessment of their level of risk. The conflict of interest in such a system is apparent, and has been made more apparent as a result of the financial crisis. One of the problems in assessment of risk is considered to be the asymmetry of information, and it therefore necessary to ensure a system where there is well financed external assessment of the risks in individual banks. The only way of ensuring this is to regulate the usage of the information provided by external assessment agencies to ensure that each individual who uses the services of the agency is restricted to using the information for their own personal use. For example, newspapers could not report the assessment of agency ‘x’ of bank ‘y’ without the explicit permission of the agency.

The regulation would ensure that there was the available finance for an effective system of external and independent assessment of the banking system, and individual banks within the system. Even within such an independent system, errors will still be made, and any assessment would need to make a statutory declaration in a regulated format advising the recipient of this fact.

The purpose of the provision of information about the banks, and the development of deposit banks, is to provide individuals with the information about the risks that they are taking, and to make informed choices as to whether they take risk. No form of regulation can remove the risk taken in any form of investment, and the only solution to this problem is to make risk a choice, and make the nature of the risk as transparent as possible. When individuals are presented with information and choice, any guarantee of the deposits by the government no longer becomes necessary, and the financial system can be largely left to operate as the market demands.

The last element of the regulation relates to the one remaining problem that might arise in the banking system. This is the notion of the ‘too big to fail’ bank. It is apparent that, if institutions become large enough, their collapse might lead to severe problems in the economy. The existence of banks of this size is therefore a danger to the stability of the economy. It goes beyond the scope of this discussion to go into detail of how banks might be broken up and regulated in order to remove this risk, but regulation of size of banks would be a necessity.

So far, a radical system of regulation and deregulation has been presented. It is apparent that a fixed fiat system is necessary to allow the deposit banks to play their role in the system. However, this does not explain how stability in the provision of IOU money might be achieved.

In order to understand this, it is necessary to think of individuals making choice according to their own circumstance and their individual appetite for risk at various points in their life. Pension and life insurance markets give a clue to how these decisions are presented and made, and it is apparent that in aggregate the total level of risk individuals will take will remain relatively stable over time. Under the current system, any deposit into the banking system is undertaken without any heed to the levels of risk in an individual bank (excepting during the recent bank runs). The assurance of government guarantees of the banking system, and deposit guarantee schemes, means that banks are able to operate with levels of risk of which the depositors are unaware.

In the system proposed, in which levels of risk are more transparent, individuals will be confronted with clear information about the levels of risk that they are undertaking. If there is an aggregate steady level of acceptance of risk, the banking system will adapt to the informed choices of individuals, and will provide a range of options that will meet the aggregate demand for risk. As that aggregate demand will normally not see abrupt changes, any change in issuance of IOU money by the banks will be dampened to reflect the aggregate risk demand in the market. Once again, there is nothing in the system to prevent manias, although the deflationary nature of the system will ameliorate the manias. As a result, in normal time, the issuance of IOU money from financial institutions should remain relatively stable and constant.

This entire system can only be achieved in a system of a fixed fiat currency, which provides the foundation of the reformed system of banking and finance.

Government Issue of IOU Money

Another potential source of issuance of IOU money is government, typically in the form of government bonds. The purchase of these bonds can be broadly divided into domestic and overseas purchases, and each has a different impact and considerations in the consideration of financial stability.

A government issued bond, as with any form of money, is a promise to return a value of labour in the future. The key difference between a government bond and other forms of IOU money is that the government can utilise the law and tax system to force individuals to provide a proportion of their value of labour in servicing the obligations of the bond. It makes them a relatively sound form of money, as they can in principle make (within some boundaries) large claims on the value of labour in an economy.

The starting point in the consideration of the issue of bonds is the purchase of the instruments by overseas buyers. This has most curious effects on the economy that receives the bonds, and upon the perception of the state of the recipient economy. Before going on to these points, it is worth reiterating that the bonds that are issued are no different from the IOUs for gardening provided by Fred in the explanation of money, with the exception that the bonds might force Fred to work the necessary hours for repayment. Just as Fred uses the bond to allow him to consume beer, a stored value of labour, a UK bond purchased by a Japanese investor allows the UK government to consume the stored value of labour of Japanese workers.

A good way of thinking about this is to imagine that the purchase of the bond by a Japanese investor is being used to build a hospital. For the sake of simplicity, we will imagine that the bond is for the building of the hospital alone, and is only purchased by Japanese institutions. As part of the purchase, Japanese currency will arrive in the UK, and that might be used to exchange for other currencies to purchase material, services and equipment, or purchase these directly from Japan. In addition to this, some of the money will be used to pay UK contractors and suppliers. In all cases the payment is being made from the stored value of labour of Japan.

If we imagine the purchase of a piece of medical equipment from Japan, at some point in the future, the promise of the bond is that value labour of a good or service slightly greater than that purchased will be returned to Japan or whoever holds the bond. When the device is shipped to the UK from Japan, it will also generate significant activity in the economy, with an importer handling the import, a logistics company moving it to the hospital, and the contractors who install it into the hospital. At each stage of the process, the value of labour being utilised is a consumption of the Japanese value of labour that was provided in the currency exchanged for the bond. However, the impact upon the economy extends beyond these discrete actions.

For example, each of the individuals or organisations that have been paid through the issue of the bond will go on to spend the IOU money provided by the bond in the wider economy. For example, a contractor may save enough money to purchase a UK built car with cash, thereby increasing output of cars in the UK economy by one car. However, whilst he is paying for the car in what appears to traditional money, he is in fact spending the IOU money from the bond. If we think of the myriad of ways in which the bond IOU money will increase output in the economy, it is apparent that the IOU money has an effect on output far greater than the headline figure. The money from the bond becomes tied up with the traditional money in the economy, and separation of the IOU money from traditional money becomes impossible.

The issue of bonds then needs to be placed in a wider context, if we are to understand the implications and effects of the bond. If an economy is running a current account deficit, then the economy overall is being provided with goods and services over and above the output of the economy. If governments are issuing bonds and these are purchased by overseas investors, the money that then flows into the economy represents an aggregate consumption of the value of labour of the creditor country. The problem that then arises is how we might actually measure the output of the economy. As has been illustrated in the case of the hospital bond, the value of Japanese labour entering the economy becomes inextricably entwined with the economic output as a whole. It generates considerable activity throughout the economy.

If we then consider that GDP measures are a consideration of the activity within an economy, it is possible to see that the GDP figure is measuring the output of Japanese value of labour output as if it were UK value of labour output. Furthermore, the greater the issuance of bonds, the greater the activity in the economy, and the higher apparent GDP will be. Issuance of IOU money in the form of bonds will increase activity in the economy, giving an illusion of growth in the economy. This becomes particularly problematic if the sustainability of bond issuance is being measured as a percentage of GDP, as that figure will include the impact of previous bond issuance, and is not representative of the output of the UK, but is representative of the output of the UK economy and the imported value of labour of Japan (to return to the earlier example).

The GDP measure of the economy does not actually represent the output of the economy, but the measure of debt to GDP allows government to continue the issuance of more IOU money than might be sustainable.

It is here that we come to the question of how a fixed fiat system might prevent such problems. The first point is to say that a fixed fiat system will not be able to prevent governments from the issue of bonds, which is of itself a dubious practice in ordinary circumstances (though the reason for this will be left aside for this discussion). However, if a country is running an overall current account deficit, under the fixed fiat system, the country will find that money is flowing out of the country, and that there is a process of deflation taking place. This deflation will make the purchasing power of the currency increase, and will therefore make the goods and services of the country more attractive, as the currency will provide more goods and services per unit. This will mean that a current account imbalance, as soon as it appears, will start to correct itself.

However, if a government is issuing IOU money to overseas investors during a period of a current account deficit, it is immediately apparent that the government is seeking to artificially maintain the current account deficit. They are seeking to prop up consumption within the economy, and in doing so are building an unsustainable economic structure. In so doing, they are issuing money against a level of output that is already unable to service the current exchanges in value of labour between the bond issuing country and its trading partners. Without the endless confusions being caused in targeting variable interest rates, different volumes of money, such reckless behaviour will be very apparent.

In other words governments will not be able to hide irresponsible policy behind a wall of monetary policy. The current account balance between countries will become main the determinant of the relationship between their currencies. In terms of exchange rates, they will become transparent, and will alter according to trading relations, not with monetary policy. Our Japanese investor will see clearly that fiscal expansion during a current account deficit is a policy that can not be sustained, and the future repayment of the bonds must see a devaluation of the currency. No overseas investor would invest into such a poor currency.

A fixed fiat system prevents governments from borrowing more money than might be supported by the actual output of value of labour in the economy. It creates transparency and clarity about the state of the economy in relation to trading partners.

With regards to the issuance of IOU money, where the purchase is made by individuals or organisations from within the issuing economy, this is more problematic. However, there is an indicative measure of whether the government is indulging in fiscal irresponsibility which is that, within a fixed fiat system, inflation should only take place in few limited circumstances, and those circumstances can be reasonably isolated from the general trend within the economy.

Barring the impact of these circumstances, in the event of inflation, it is apparent that the government is issuing more IOU money than can be supported by the output of value of labour within the economy. Any inflation within the economy can be seen as a warning sign, and it is then a matter for the electorate to discipline the government for causing the inflation. This moves beyond economics, and is the question of how a mature democracy might function, and is therefore beyond the remit of this discussion. How or when a government might be disciplined is firmly within the realm of the relationship between governance and the democratic system.

Overall, the fixed fiat system provides clarity about the actual state of the economy, and also provides some mechanism of stabilisation of trade between countries. It is a system which should, in most situations, offer considerable stability and ensure that an economy grows in a sustainable way.

The Problem with a Fixed Fiat System

There is a problem with a fixed fiat system in a world in which the current fiat system holds sway. In particular, there is the problem that a fixed fiat currency would be very attractive to investors who have their domestic currency operating in a conventional fiat system. In particular, they will know that the value of the currency will never be eroded through the issuance of greater volume of the currency. As such, over the long term, it will appear to be a stable and secure form of money into which a person’s value of labour might be stored.

The problem that this stability represents is that it will encourage a situation in which the stability of the fixed fiat currency will be undermined by the apparent stability of the currency. It is a contradiction that requires some explanation.

If, for example, the UK switched to a fixed fiat currency, and Japan remained on a standard fiat system, then Japanese individuals would likely want to place their stored value of labour in the UK. The result of this would be to see lots of Japanese investors seeking places to put their money in the UK. For example, government bonds would appear to be attractive, offering considerable security. However, as has been detailed, the issuance of government bonds is in fact the issuance of money. As such, if the government, or other recipients, of Japanese investments accept the flood of Japanese money, the money supply will have increased, which is inflationary.

The problems that this might cause are best illustrated with the carry trade from Japan. The carry trade was resultant from the policy of quantitative easing in Japan in conjunction with low interest rates in Japan. The result of the policy was that, as fast as new traditional money was added to the Japanese money supply, money flooded out of Japan seeking higher interest rates in other countries. In so doing, the increase in the money supply helped create the asset and credit bubbles in countries such as the UK. Furthermore, the money that was being created was earning a rate of interest that helped counteract any loss of value of the Yen that should have resulted from the increased issuance. The investment of the money flowing out of Japan contributed to the positive current account balance of Japan, thereby strengthening the Yen.

In other words the targeting of interest rates and quantitative easing was a contributory factor in the development of imbalances in the world economy. It illustrates the danger in conventional fiat money systems, and these kinds of imbalances would appear in any economy with a fixed fiat system.

The only solution to this problem is that all currencies should move to a fixed fiat system. Under such a system, there would be no targeting of interest rates, as the money supply could not be manipulated, and also there would be no possibility of quantitative easing. In a world built around a fixed fiat system, the world economy would look very different. For example, if we imagine our Japanese investor, his choices will look very different.

In determining where to place his money, he will no longer be looking at the relative prospects for any individual currency in terms of monetary policy of the country, but will be looking at the fiscal policy of the country, and the output of the value of labour in the country. The interest rate in the country will no longer be set by the control of issuance of money, but by the conditions of the market in the country.

The only way such a system might be enacted would be through international agreement. For example, if the G20 were to agree to the system, and made trade with any country conditional on implementation of the system, then it would become the world currency system. The problem that arises is that the system would run counter to the quasi-mercantilist currency policies undertaken by countries like China. It would also present a constraint on governments borrowing from overseas sources, and this would force them to have to confront the underlying economic difficulties within their countries. Whether there could be any agreement in these circumstances is questionable.


So what is the key, the underlying principle behind the fixed fiat currency system? With a little reflection, it is apparent that the underlying driver behind the many benefits is the shift to something that becomes a representation of the actuality of the economy. It creates transparency, and thereby creates systems that are inherently stable. It removes power from the regulators, the central banks, the government and the financial system, and transfers and distributes that power into the wider economy. It is essentially a democratic reform.

Even if this reform of money were to found to be a sound and coherent approach to the management of money in the economy, it is unlikely that it would ever be enacted. It hurts too many interests, and those interests would fight any implementation of the system. However, if the system is workable, this paper is written and published on the basis that it is better to have an alternative system ‘out there’ in the world, rather than locked away in the thoughts of one individual.

I therefore conclude the article with two points. The first is that I am profoundly pessimistic about the prospects of any change which might remove the privilege and power of the banks, and even more pessimistic about the prospects of government accepting such reform. The second point is to reiterate the point at the start of the article. This is the musing of an individual without any schooling in economic theory. As such, thoughts, comments and critiques (hopefully polite) will be welcomed.


Note 1: I am not sure how many might reach the end of the article, but I hope at least a few will find it worth the effort. For those who do get this far, I would like to thank you for your patience.

Note 2: I use Japan as an example on several occasions for illustration and examples. This is not to single out Japan as a particular source of problems, but rather the country is used for ease and consistency.

Note 3: A couple of the examples I have used for the deflation argument have been used elsewhere (I forget where), but I also used these examples in an article a long while ago, so I have not referenced the article.

Note 4: The Austrians will object to the fixed fiat system, as they believe all currency should originate in the 'market'. I see no reason for this, and would be happy to see a commodity currency compete with the fixed fiat. I am confident about which might win over as the chosen currency used by most people. It is also noteworthy that in reality, for a commodity currency, they are actually discussing gold and silver, both of which have considerable variation in value over time. This is an inherently unstable currency. I also had a brief debate on the subject of a fixed fiat currency system on the von Mises website. They suggested any fiat currency would be subject to debasement. My pointing out that commodity currencies have been debased throughout history fell on deaf ears.

Note 5: Suggestions and further ideas are welcomed. This is, after all, the first attempt to outline this system.

Friday, July 17, 2009

Bleeding the 'Real' Economy to Support the Financial System

I am in the highly unusual position of agreeing with Krugman (or at least in part), the Nobel winning economist who writes in the New York Times. He has just recently written an op-ed on the subject of the huge profits being achieved by Goldman Sachs ($US 3.4 billion), and says the following:

The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. If you’re a banker, and you generate big short-term profits, you get lavishly rewarded — and you don’t have to give the money back if and when those profits turn out to have been a mirage. You have every reason, then, to steer investors into taking risks they don’t understand.

And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong.

Inevitably, the massive bonuses that Goldman are about to distribute are a major point of the controversy. However, whilst this is all good populist material, the focus should be on a system in which the banks were bailed out in the first place. As Krugman identifies, it is a case of 'heads they win, tails other people lose'. Krugman, I recall, was in favour of 'saving' the financial system, as were many others. What we are now seeing is the result of the 'salvation' of the system. The banks that took huge bad bets are now appearing to make large profits.

Regarding Goldman Sachs as the evil in the machine, the populist mantra of the day, I will not criticise them. Provided that they act in the law, their duty is to do the best possible for their shareholders, and also their employees. Goldman Sachs are simply doing a very effective job within a framework that allows them so much leeway. They are no different from GM in holding out their hand for government support, but are simply more effective at doing so. Goldman Sachs are just a symptom, and are certainly not the cause of the problem. It is not their role that should be subject to criticism, but the government and the Federal Reserve - it is the state that is the problem. It is the state that is at the root of the appearance of the bumper profits and bonuses at Goldman Sachs.

I say 'appearing', as there are real question marks over how 'real' these profits actually are. The bailout of AIG has been linked to an indirect bailout of Goldman Sachs, for example by the bane of Goldman Matt Taibbi of Rolling Stone magazine. On top of AIG, it is not clear how much Goldman has been bailed out by the various programs that have been enacted to remove toxic assets from the balance sheets of banks, as the recipients of such bailouts is shrouded in secrecy. There are also the changes in accounting rules have allowed banks to do some extraordinary accounting tricks:

During the financial crisis, the market prices of many securities, particularly those backed by subprime home mortgages, have plunged to fractions of their original prices. That has forced banks to report hundreds of billions of dollars in losses over the last year, because some of those securities must be reported at market value each three months, with the bank showing a profit or loss based on the change.

Bankers bitterly complained that the current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their value in a normal market. At first FASB, pronounced FAS-bee, resisted making changes, but that changed within a few days of a Congressional hearing at which legislators from both parties demanded the board act.

This is just one example. In other words, as a result of the bailouts and the changes to the accounting rules, it is nigh on impossible to work out exactly where any real profits might lie. Quite simply, nobody but the banks themselves and the Federal Reserve, and perhaps other arms of the government, can untangle the real state of the banking system. However, it is almost certain that the sudden profitability of the banks is rooted in the various bailouts and accounting tricks. Whilst it is quite plausible that many parts of the Goldman operations are profitable, the overall genuine profitability is buried in the accounting and the bailouts. Krugman identifies the complete opacity of the situation as follows:
I won’t try to parse the competing claims about how much direct benefit Goldman received from recent financial bailouts, especially the government’s assumption of A.I.G.’s liabilities. What’s clear is that Wall Street in general, Goldman very much included, benefited hugely from the government’s provision of a financial backstop — an assurance that it will rescue major financial players whenever things go wrong.
Under such conditions, it is no wonder that so many commentators are calling 'foul' over the massive bonuses that are going to be paid out by Goldman Sachs to their employees. However, the underlying problem remains as to why all of this has taken place. Why have the changes to the accounting rules taken place, and why are toxic assets being taken off the hands of the banks, thereby transferring risk from the private sector to the state sector?

The argument has been that certain financial institutions are 'too big to fail', but the reality is that the various government measures to support the situation is entrenching the system in which the large financial institutions threaten the financial system. With each bailout, with each measure, they undermine the market forces which might discipline the banks, creating ever more public exposure to private risk taking. In doing so, they simply embolden the banks to take further risks.

As was identified at the start of the process of the bailouts, there is an inherent moral hazard in bailing out banks, in that they cannot lose. They become a one way bet, and that will, however much oversight is applied, eventually lead to complacency, and excessive risk taking. It is now apparent that, under the current system, profit is guaranteed by public institutions. The worst case scenario for the major banks is that they might have a few quarters of poor or no profits, but there is an implicit guarantee that the government will do whatever is necessary to engineer a return to profitability. There will be no more Lehmans in the future, as the new regulatory regime will never allow another major bank failure for fear of a repeat of this crisis. One way or another, the 'too big to fail' banks will be immune from any major losses.

The solution given by many, like Krugman, is more supervision and regulation. However, if a bank is 'too big to fail', with proposals for special levels of supervision as a result, it will become to be seen as the 'safest' kind of bank. If a bank is seen as 'safe', it will offset any measures such as stronger capital adequacy requirements through being able to raise finance more cheaply, and through the state guarantee will win more business, and the result will be to just get bigger, and consolidate ever more risk into a small number of institutions. The crisis has already seen a consolidation in the number of major banks, and this process is likely to continue.

The problem is that the same regulators who failed to see the risks in the current system will be responsible for regulation under any new system. Whilst they might (possibly) be able to spot the kind of risks that caused the current financial meltdown, what is to say that they will be able to spot the risks that arise in the next particular set of economic circumstances? The difference is that, next time around, it is more likely that there will be even more concentration of risk in a few major institutions, and therefore even greater system-wide risk.

If you doubt what I am saying, take a look at one of the key policy makers discussing the state of housing and the financial system pre-crisis. I found this video of pre-crisis statements by Bernanke on Reddit recently. For the many out there calling for more regulation, you will need to think about how the regulators might be able to identify risk, when the record of policymakers is so abysmal. Quite simply, the policymakers who will formulate the regulation are clowns dressed up in important titles, armed with mechanistic formulae and jargon.

Whilst all of the shenanigans continue in the financial sector, the 'real' economy in the US continues to bleed. At some point in time, it is the real economy that will have to pay the price of the salvation of the 'financial system'. Again, I find myself agreeing with Krugman:
The bottom line is that Goldman’s blowout quarter is good news for Goldman and the people who work there. It’s good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But it’s bad news for almost everyone else.
The fact is that, one way or another, the 'real' economy will eventually be paying for the profits at Goldman and the massive bonuses, and that 'real' economy is already suffering extreme pain. In the meantime, it is not apparent that the 'salvation' of the financial system has translated into salvation of the economy. For all the talk of 'green shoots', the US economy continues on a steady descent, with all the pain that means for those working in the 'real' economy.

The panic engendered when the financial crisis hit is now over. I argued against the bailouts at the time that they were taking place, at that moment of panic. I argued that the resource being poured into the banks would be needed whilst the economy restructured. I argued that the bailouts would continue on from those that were proposed at the start, and that is what has taken place. And.....every single $US that has been poured into the rescue of the financial system will one day be repaid in taxation from the 'real' economy. I argued against the bailouts on this principle.

All of this, hidden in opacity, has led to a point at which insolvent banks are now able to make a 'profit'. Exactly why has this massive bleeding of resources into insolvent banks been allowed to take place? Where exactly is the salvation of the real economy, the pot of gold at the end of the rainbow of the financial system? Like the pot of gold and the rainbow, if we just go a bit further.....we might just find the pot of gold.

In this terrible mess, the point that is forgotten is what a financial system is actually really for. It only exists to allocate accumulated capital and provision of insurances; the financial system should be a support to the real economy, by efficiently allocating capital. It is entirely unclear how pouring trillions of dollars into insolvent institutions, capital which will eventually be taken out of the 'real' economy, might facilitate this. The 'real' economy is now expensively supporting the financial system, rather than the financial system supporting the real economy. It seems that this is the exact opposite of what a financial system actually should be doing. It is simply beyond any reasonable explanation.

It is the same policymakers who are supporting the financial system at the cost of the economy who will be formulating the new regulatory framework. It is the same policymakers who failed to see the risks inherent in the financial system that will be overseeing and regulating the future risks in the financial system. It is the same policymakers who have overseen the consolidation of the banking system into fewer hands, who are engineering a system in which banks will be ever more concentrated. It is the same clowns who were responsible for the current mess in the financial system, who have engineered that insolvent institutions make profits, that will suddenly have the wisdom to create a 'safe' financial system in which major risk is banished.

It is not an encouraging prospect.

Note: The use of the term 'real' economy is a convenience, as the financial system is actually part of the real economy. As such it is used simply as a way of saying that I am referring to the provision and exchange of services and goods outside of the financial sector.

Wednesday, July 15, 2009

Questions for the Deputy Governor of the BoE

I have long been arguing that the Bank of England's purchase of gilts with printed money (so called quantitative easing - QE), has supported the UK bond market and that the Bank of England has effectively been monetizing the debt of the UK government. In my most recent post on the subject, I identified that overseas holders were selling gilts to the Bank of England, and that QE was supporting prices. In a slightly earlier post, I showed how the Bank of England rationale for QE made no sense whatsoever, and that it was just a cover for propping up the massive UK fiscal deficits. My criticisms of the policy date back to before it was even enacted, and I even predicted that it might be enacted as the fiscal situation deteriorated.

The fig leaf for such monetization has been that the action has been taken to prevent deflation. However, it is only now that the CPI measure of inflation that is targeted by the Bank of England has finally fallen below the target of 2%. Even now, it is just undershooting slightly at 1.8%. Even at slightly below target, it is difficult to see why such a radical policy of QE might be justified, as such a level does not even require a letter of explanation to be written.

I have returned to this well worn subject as yet more evidence of the necessity of QE to support gilt prices has emerged. In an earlier post I speculated that the Bank of England might be losing patience with the government's fiscal incontinence, and they have recently put on hold the possibility of extending QE beyond the original £125 billion of the original policy. The result is reported in the following from Reuters:
Government bonds tumbled on Thursday, propelling 10-year yields almost a fifth of a point higher after the Bank of England announced no increase to its quantitative easing programme.

With the economy still reeling after its sharpest contraction in more than 50 years, markets had widely expected the central bank to increase its asset purchases by 25 billion pounds.

Traders fretted that its decision to leave the target unchanged meant the Bank's unprecedented scheme to buy assets, over 90 percent of which have been gilts, may soon be brought to an end.

Ian Kernohan, an economist at Royal London Asset Management, said the knee-jerk rise in gilt yields gave some indication of the size of the QE premium in gilt prices.

"The problem will be how to exit the QE strategy without causing a significant back up in yields and the cost of funding the government's deficit," he said.

The September gilt future settled 1.45 points lower, sharply underperforming the equivalent Bund future which fell just 24 ticks.

The key part of this article is that the fall was not as a result of the Bank of England stopping QE, but as a result of no announcement of an increase in the QE programme. As some of the analysts described it, it appears that there was a belief that it was just a delay in the announcement of an extension of the programme:

Some analysts saw this as a hint an extension to the programme had merely been delayed until next month, when it will be able to explain its actions more fully.

"This probably does not sound the death knell for QE," said Philip Shaw, chief economist at Investec. "Rather we expect an increase next month, when the monetary policy committee will have the benefit of a fresh set of inflation projections," he added. The Bank indicated that it would slow the pace of its gilt purchases, buying just 4.5 billion pounds of gilts next week. Since April, the central bank has been buying gilts at a rate of 6.5 billion pounds a week - roughly double the rate at which the government has been issuing them.

It is apparent that even a hint towards an ending of QE is enough to set the markets on edge. The result is that Charles Bean of the Bank of England has since needed to offer hope to the markets by saying the following:

"We haven't paused on QE. We are committed to buying 125 billion pounds of assets that will take us through to August," he was quoted as saying.

"We decided last week there was no need to make a firm decision. and we could afford to wait. August is when we publish papers on the economy and it's a natural point at which to take stock."
It is apparent that the state of the gilts market is now largely being determined by Bank of England purchases, and this really is the monetization of debt that I have long considered to be the result of the QE policy. The fragility of the gilt market, and the necessity for QE to support the market have been revealed.

One of my regular readers has identified that Charles Bean is taking questions on the policy of QE and suggested that I ask him some questions about QE. At this stage, this seems the best way of seeing how the Bank of England might justify the policy. As such, I have sent the following questions.
1. Reuters has reported on the 9th July that, following no announcement of an extension of the policy of QE by the Bank of England, bond yields rose sharply. Bearing in mind that just the possibility of an end to the policy caused this reaction, does this not suggest to you that QE is propping up the Bond Market?

2. The CPI has finally dipped below the 2% target that the Bank of England uses in setting monetary policy, but is still not far enough off target to require a letter of explanation. I believe that the Governor of the Bank of England has identified QE as an untried unconventional policy with uncertain outcomes. Bearing in mind that, during all but the last week, CPI has not fallen below target, how can such an untested policy be justified? In particular, with monetary stability as a key aim, how can such an unconventional policy be justified?

3. With regards to exit strategies for QE, the Bank of England Quarterly Bulletin for 2009 Q2 states that 'Alternatively, the supply of reserves could be reduced without asset sales, through the issuance of short-term Bank of England bills.' Is this policy? If so, can you confirm exactly when and under what circumstances you will finally sell the gilts that have been purchased?

4. A secondary question as a follow on to question 3. If the purpose of QE is not to monetize government debt, then why would you not sell gilts at the end of QE policy? Do you have concerns that the existing expansion of gilt issuance would preclude the sale as the sale might destabilise the gilt market? Is this not recognition that the gilt market can not support the current level of issuance?
I do not know whether I will get answers, but it is certainly worth asking the questions. I will update you on any reply that is made. In the meantime, it is apparent that the Bank of England is locked into QE if it does not want a collapse in the gilt market. They are faced with the tough choice of supporting government irresponsibility, or seeing a gilt market collapse and the resultant fallout for the £GB. On the other hand, if they continue, the situation can only get worse, as the economy slides further down, and government borrowing continues to climb.

It is a tough position to be in. However, I hope that they might conclude that it is better to face the problem now rather than later, at which point it can only be far worse.

Saturday, July 11, 2009

The Danger in GDP Measures

Some time ago I read an interesting paper from within the field of academic economics. The article, by Ole Rogeburg was written pre-economic crisis, and was titled 'Taking Absurd Theories Seriously: Economics and the Case of Rational Addiction Theories'. Perhaps the most important point of the paper was that it was a case study to illuminate what he saw as a more widespread problem.

I will not detail the entire argument of the paper, but he identifies that economists used mathematics to present a completely absurd explanation of drug addiction, and that the resultant nonsense has been used in the formulation of government policy. The most striking element of the discussion is how the completely implausible might become plausible with the backing of clever academic argument, and the respectability of a veneer of academic rigor.

One of the themes of this blog has been trying to view the current state of the world economy as it might be observed in the circumstances of today, rather than through any particular perspective derived from academic economists. As part of that process, one of the problems with economic theories that I have identified is the obsession with GDP figures as a measure of the health of an economy. I might even go as far as to say that the subject has become something like an obsession of my own. As such, I hope that I will be forgiven a post devoted to the subject, and which pulls together some earlier points that I have made.

Before I continue further, I will quote the understanding of GDP that is described in the UK's official publication of statistics, National Statistics online:
Gross Domestic Product (GDP) is an integral part of the UK national accounts and provides a measure of the total economic activity in a region. GDP is often referred to as one of the main 'summary indicators' of economic activity and references to 'growth in the economy' are quoting the growth in GDP during the latest quarter.

In the UK three different theoretical approaches are used in the estimation of one GDP estimate.

GDP from the output or production approach - GDP(O) measures the sum of the value added created through the production of goods and services within the economy (our production or output as an economy). This approach provides the first estimate of GDP and can be used to show how much different industries (for example, agriculture) contribute within the economy.

GDP from the income approach - GDP(I) measures the total income generated by the production of goods and services within the economy. The figures provided breakdown this income into, for example, income earned by companies (corporations), employees and the self employed.

GDP from the expenditure approach - GDP(E) measures the total expenditures on all finished goods and services produced within the economy.

The estimates are 'Gross' because the value of the capital assets actually worn away (the 'capital consumption') during the productive process has not been subtracted.
Whichever approach is taken, the key point is that the measure is made of activity, and therein lies the problem. A whole host of factors might determine activity, but they offer no indication of the health of an economy.

For example, if we look back to the devastation of Hurricane Katrina, there was a massive programme of rebuilding following the destruction of so much infrastructure. The infrastructure that was destroyed represented an accumulation of investments being destroyed, or the destruction of wealth represented in infrastructure. However, the replacement of the infrastructure would be represented in activity such as construction and cleaning up the areas of devastation. This would, in turn, feed into the GDP figures, such that GDP would see a rise as a result of the devastation of a city. As such, whilst GDP does indeed represent activity, it can not be said to mean 'growth in the economy'. In other words, can replacement and cleaning up of this destroyed infrastructure represent economic growth?

If such a view of economic growth is taken seriously, then the logic of the measure would suggest that a good way to achieve economic growth would be to destroy infrastructure such as factories, roads, bridges, houses etc.

There is an even more significant worry about GDP and the way it is used. An example is taken at random from the news on a Google news search for the term 'US debt % GDP', and produced this article:
The UK is drowning in debt. The total amount owed by our households, firms and the government is staggering – more than five-times our national income. On top of that debt stock, the UK is heading for a 2009 budget deficit of 14pc of GDP – by a long way the biggest in our peace-time history.
I actually support much of what the author this quote says (Liam Halligan of the Telegraph), but think that he is making a major error using GDP as any kind of a reference point. I will explain why.

As I have already identified, the measure of GDP is a measure of activity in the economy. As such, it is a measure that takes no account of the source of activity, such that a hurricane's devastation might increase GDP. However, included in the level of GDP is the economic activity that is resultant from the debt driven consumption. If we then view the idea that debt is '14 pc of GDP' we encounter a problem. What is being measured is the proportion of debt in relation to economic activity that is itself, in part, driven by debt. The economic impact of that debt is itself difficult to quantify.

For example, here are two charts from the UK National Statistics website, regarding fiscal deficits:

The problem that arises is that the measure on the left shows the money that is being borrowed, and the chart on the right shows the total economic activity that includes that borrowing. It is when we see how debt driven consumption actually impacts on the economy that the scale of the problem makes sense.

For the sake of simplicity, we might imagine that a small slice of the money that is borrowed by the government is used to pay the salary of one individual. When that individual goes shopping and purchases a shirt, they will spend some of that borrowed money. The purchase of the shirt will register as economic activity. However, the story does not end there. The retailer will then need to order another shirt for stock, and this will then see economic activity in a wholesaler, which in turn might see economic activity from an importer. Furthermore, the money spent on the shirt will contribute to many of the support services that are a necessary part of retail, creating ever more activity. The money will then contribute to the wages of the staff who will then spend the money, creating yet more activity.

In other words, this tiny slice of the government's borrowing will generate activity far in excess of the headline figures, or in this case in excess of the individual's salary. All of that activity will be recorded in the GDP figures.

The problem that this generates is to ask how the activity that is generated by debt might be stripped out. I will confess that I do not know the answer to this question (comments welcomed), but it is certain that GDP is a measure which has little meaning in the measurement of an economy. More borrowed money results in more activity in the economy such that the measure of the economy becomes a measure of the borrowing against output that includes activity from previous borrowing. The big question here is how a measure that does this might be an indicator of the sustainability of borrowing?

To illustrate this, imagine if a factory's performance was measured against activity rather than cash flow or profitability. The owner of the factory might produce more product if they borrow more money for materials, labour and power, but that would do nothing to indicate the health of the company that owns the factory. If a measure like GDP were used, the output resultant from the borrowing would be seen as an indicator of a healthy business, even though the accumulation of debt would suggest otherwise. However, the measure would consider the debt in relation to the activity, such that the debt accumulation would increase activity, and this would be represented in output. I am not sure this is the clearest description, but I hope the underlying point is clear (if you can phrase it more clearly, please feel free to add a comment).

I will use a related example from a recent post as a further illustration. If an individual earns £50,000, and borrows £10,000 per year, they appear to have an income of £60,000 in their lifestyle. If GDP type measures are used, then the sustainability of the borrowing of £10,00 a year would not be measured on the actual £50,000 of income, but would instead be measured on the apparent income of £60,000 per year. Nobody in their right mind would do such a thing, but this is in effect what GDP measures are doing.

The reason why I highlighted the problem with economic theory at the start of the post is to point out that economics can be a matter of playing with clever ideas. GDP is just such an idea. It seems to be a perfectly rational and clever idea, that an economy's output might be measured through the activity in the economy. However, if an economy is being financed in part by debt, the meaningfulness of the measure completely disappears. Even when an economy is not partly funded through debt, the Katrina example illustrates how fundamentally flawed the measure actually is. It ceases to have any plausibility. Just as with the drug addiction thesis, GDP is being used by economists to shape government policy, but it should be viewed as a nonsense.

The idea that this measure is one of the most important measures in shaping fiscal and monetary policy is deeply disturbing. In particular, GDP is falling in an environment when there is an explosion in government borrowing. If it were possible to strip out the impact of the government borrowing from these figures, then the situation of the absolute borrowing versus the absolute output without the borrowing would reveal a very, very ugly picture.

We have witnessed a private credit bubble economy (in conjunction with expanding public debt) and have seen the damage that this has wrought. During the entire time the damage was being done, the GDP figures created an illusion of a healthy economy. We are now witnessing a massive increase in public borrowing, and again the GDP figures flatter the relative success of the policy, hiding the severity of the crisis, and likely unsustainable debt. With regards to how unsustainable this policy might be, there appears to be no way to measure this, just as there was no way during the private credit bubble.

The problem that then arises is how to determine the actual health of an economy. The answer is actually surprisingly simple. The actual health of an economy overall is determined by whether the economy can be sustained without any borrowing. If borrowing is necessary in aggregate, whether the source of the borrowing is private or public, the economy is unhealthy. In other words, an economy's sustainability is determined by the ability for the economy to have aggregate output which matches the aggregate consumption.

The only question that remains is how to determine how bad borrowing might be, and for this I can offer no solution. However, in economies like the US and UK, the numbers are shockingly large relative to the history of borrowing, and should therefore be a cause for worry. In particular, when comparisons are possible with the debts accumulated in a period of total war (World War II), then there is real cause for worry. Such comparisons suggest that the situation is indeed extremely bad.